After introducing a few basic principles last week of how you can change yourself to be wealthy, this week I want to introduce risk and how the wealthy manage it.
It is important that we consider risk at this stage of your journey as it is one of the most significant factors that sets the wealthy apart from the poor.
The simple truth is that without some risk it is highly unlikely that you will achieve financial freedom.
Sure you can put your money in the bank and earn the risk free rate of return, but have you looked at what is happening around the world with interest rates? Rates are at some of the lowest levels seen in history and Europe and Japan currently have negative interest rates…
So if you want to make the type of returns required to become wealthy, you can’t rely on risk free rates and will therefore have to take some risk.
And this is where the wealthy separate themselves from the poor.
The wealthy look for opportunities to invest their money that have the potential to produce growth, and in some cases income as well.
The alternative is to avoid risk, see risk as an obstacle or reason not to do anything, that is, to procrastinate…
I’ve been there, after the stock market crash of 2001 I took a long time to decide it was appropriate to re-enter the market. My delay cost me, but also taught me a number of lessons, one of which was to understand risk and how the wealthy manage it.
It is also worth noting, that the wealthy don’t seek to eliminate risk, for this is generally not possible or preferable.
As I stated earlier, to achieve returns that will progress you in your wealth creation journey, you need to have an element of risk in the investment.
Your return is a factor of the risk in the investment… The higher the risk, the higher the expected return, makes sense, right?
How the Wealthy Manage Risk
The wealthy have a consistent approach to risk that comes down to these key items:
- Having a Plan
- Due Diligence
The first step in managing risk is to understand your appetite for risk, i.e. how much risk are you prepared to manage.
This will be different for each person and dependent on your circumstances.
As you start out you will be less likely, or should be, to take on big risk.
As you start to build your wealth you may start to take on riskier investments, knowing that you have built up some money to cope in the event that the investment doesn’t play out as expected.
Having a Plan
This is my go to requirement for anything when it comes to investing, you have to have a plan…
When you are investing you need to have a plan of how you are going to go about achieving financial freedom, and this plan needs to have considered risk and what you are going to do to manage it.
If you don’t plan, if you don’t consider the downside before you start, you are likely to make less rational decisions when faced with a difficult circumstance.
However, if your plan stipulates what you do in the event of a risk event, you can simply manage the situation by implementing your plan.
Of all the wealthy people I have studied, this is by far the most consistent theme in terms of risk that they all share.
Wealthy people research their investments BEFORE investing.
I am sure you have heard the horror stories of people that have invested in a property development or stock because a broker or friend told them it would be the next big thing.
Current affairs news programs run these stories almost on a monthly schedule.
In most cases, these are people who haven’t done any research of their own.
I accept that there are some scenarios where people have been misled in their research, but generally speaking, if you don’t do your OWN research, your risk is inherently higher.
This is similar to research, but extends to include doing some scenario testing.
The wealthy will analyse their research and then apply what they have learned to different scenarios for the investment to determine if the return and risk are worthy of their money.
A good example of this is looking at historical growth rates in a suburb and comparing to predicted future growth rates for reasonableness. If the numbers don’t make sense, the wealthy won’t invest, they move on to the next opportunity.
The due diligence step is about making educated risk decisions based on information and facts.
Diversification is an interesting topic, one that I have found the greatest variation in how the wealthy apply it to their management of risk.
The most common and popular view is that diversification means ‘don’t put all your eggs in one basket’.
That is, spread your investment dollars across markets, and within markets across sectors, so that if any one market or sector tanks, you are protected by the others that are assumed to be performing better.
This strategy doesn’t always work… stock markets for example have been known to plummet across all sectors at the same time.
But for investors just starting out and getting to know what asset class works best for you, this is not a bad place to start.
The final step is the safety net of insurance.
In most investments there are forms of insurance that will provide some risk management, that is they will not eliminate it, but provide some protection.
Some examples include building and landlord insurance for property investors, or derivatives for stock investors, i.e. options.
I teach all about these concepts in my property and stock investing courses that will be released soon.
How did you get on after last week’s post, have you started to work on eliminating any debts?
I saw this great quote during the week, which given it is US Masters Golf time, it is appropriate that it come from someone who I admired as a sportsman and now as a businessman.
“There is one thing that separates successful people from unsuccessful people: the ability to turn strategy into action. Nearly everybody comes up with plans and dreams. But few actually do something about them.” – Greg Norman
Remember that one of the four essential requirements to be wealthy in my Wealth Formula is Action. So make it your goal to take action this week.